Mr. Rose is Director of Economic Education, Associated Industries of
Inflation is one of the most important, yet least understood, issues of our day. Contrary to what we might be led to believe by the news media and some high economic advisors, inflation is not a rise in the general level of prices (often referred to as an increase in the cost of living). Inflation is simply an increase in the supply of money. This increase in the number of dollars in relation to the goods and services that are put up for sale causes people to bid up prices. Thus, a general rise in prices is the effect of inflation. More dollars is the underlying cause of the higher prices.
We first must recognize this cause-effect relationship before we can understand the problems and dangers of inflation. Likewise, once we understand this relationship, we can easily see through the fog created by statements like the following, made by high-placed people in our nation, when the inflation (money expansion) has already taken place!
"Fortunately, we have been free from inflation and the expectation of imminent inflation."… or "The deficits in the last three years have clearly not been inflationary."
Statements such as these give people the mistaken idea that inflation and a rise in prices are identical when, in truth, it is inflation that produces higher prices. It is because Americans have accepted such statements as true that we have engaged in worthless battles to fight rising prices, when the real culprit has been an inflated money supply. In other words, we, like Don Quixote, have become excited about phantom windmills only to leave the real problem untouched. As a doctor would say, we have been trying to cure the fever instead of the illness.
What Causes Inflation?
Expansion of our money supply (inflation) takes place through our banking system. The Federal government can, and does, cause new dollars to be created through IOU’s (bonds) that it issues. This is how the process works:
1. Congress votes to let the government spend more money during the year than it will collect in taxes. This authorizes the U. S. Treasury Department to print up enough IOU’s (bonds) to cover the difference between taxes collected and the amount of money it will spend. (At this point inflation has not yet occurred.)
The Treasury Department sells these IOU’s through dealers to anyone who will buy them. If you or I buy one of these bonds, this act is not inflationary because we use dollars that we have saved.
In other words, we just transfer dollars that are already in existence. Our purchase does not add to the money supply.
2. But when a commercial bank purchases or loans money on these government IOU’s, new checkbook money can be created because the bank may pay for the bonds by creating a deposit. (It is at this point that inflation actually occurs.) In addition, the official reserve ratio, which is set by the Federal Reserve Board, tends to have a multiplier effect of about six to one on the new money. All this newly created money competes with your dollars and my dollars to buy existing goods and services. It is this increased dollar competition that causes prices to go up.
Some Results of Inflation
As we have just seen, when government causes an artificial increase in the number of available dollars, the increase tends to reduce the value of existing dollars. It’s like adding water to lemonade. Volume increases but the lemonade becomes weaker, and it takes more of the weaker lemonade to do the same job. But that’s not all that happens. In addition:
1. Inflation insidiously transfers wealth and purchasing power from the pockets of savers to those who borrow. The value of money that has been saved becomes less as dollars become more numerous. Borrowers later can repay their loans with cheaper dollars. This is one way in which government can cause wealth to be secretly transferred from one person to another—a process that must seem unfair to aging persons who have toiled and saved during a lifetime only to have the value of their savings melt away.
Another way in which inflation secretly transfers wealth is that the normal distribution of income is upset. The newly created dollars cause prices and wages to rise first in the areas and industries where the government spends them. People who first receive the newly created money get a chance to buy goods and services before the inflated money supply causes a general rise in prices. As the new money begins to circulate and causes people to bid up prices, the unfortunate people at the tail-end of this cycle are faced with the problem of paying higher prices before their incomes go up. And when their incomes finally rise, another cycle of inflation and rising prices is already started, so they are always behind. Thus, certain people in the economy get a government-bestowed advantage over the others.
2. Inflation kills incentive to save. When savers realize that their dollars buy less when paid back after a period of time, they tend to spend their extra dollars instead of saving them. Or, as an alternative, they increase the amount of interest charged to borrowers to make up for the future loss of purchasing power. The high rates of interest charged in countries with advanced inflation is an example of this. For instance, if the going rate of interest is 5 per cent, but lenders expect the purchasing power of money to drop by 10 per cent during the next year, they will want to charge interest of about 15 per cent for use of their money. In other words, as the incentive to save goes down, the cost of inducing people to save goes up.
3. Inflation works to lower our standard of living by reducing the productive capacity of our economy. Our high standard of living in
People generally aren’t aware of how thin the line is that separates those countries that have progressing economies from those with stagnant or declining economies. Investigation will show that the so-called underdeveloped nations are the ones where people have not had the needed motivation to save part of their incomes for investment in tools of production. Thus, these nations have economies whose productive capacities can’t catch up with their booming populations. The
4. Inflation causes boom-bust cycles like we saw in 1924-38. At first, inflation produces conditions that seem favorable to everyone. Profits go up because selling prices tend to keep ahead of business costs for a while. This induces businessmen to increase plant investment, which causes employment to expand. Wages start going up, fewer businesses fail, and people generally come to believe that the key to continual prosperity has been found. But then demand for the various factors of production—land, labor, and capital—goes up. This increased demand causes their prices to rise. And these prices are business costs. As business costs rise, profits go down, plant investment is cut back, and employment drops. This is the "bust" half of the earlier “boom." This readjustment lasts until costs come down and business activity again becomes profitable.
5. Inflation distorts business results, which is one reason for the above boom-bust cycle. Real profits aren’t nearly as big as they appear because they are overstated. Part of a company’s reported profit (the amount it pays taxes on) is only "paper profit" and must be siphoned off and put with its depreciation allowance to buy higher-priced equipment as old machines wear out. If the company didn’t use part of its profit to do this, its productive tools would gradually become so old and worn out that it could no longer compete in the market place. It would lose money and finally be forced out of business.
In addition, fluctuating price-cost relationships make it more difficult for a company’s cost accountants to accurately evaluate the profitability of interlocking business operations. Thus, early losses are not noticed, and needed business adjustments are delayed. This delay causes a less effective use of resources which increases costs.
6. Inflation promotes greater intervention in the economy. As inflation-produced recessions get underway, business gets blamed for the downturn, and people turn to government for help. They mistakenly hope that government can come up with quick and painless solutions for the very economic problems that government caused in the first place! Business still carries an undeserved stigma for the Great Depression of the 1930′s.
The resulting governmental intervention leads to price, wage, and other controls that reduce individual freedom and initiative. These controls further complicate private enterprise activities, and an endless chain of controls is underway. The result is a continued centralization of power in the Federal government, such as we are seeing today.
7. Inflation hurts people of modest means (the working man) most. It is "the little guy" who is the net creditor in our society and who gets hurt during the "boom" as well as in the "bust." When prices rise, his dollars—which are mostly invested in savings accounts, insurance, and other fixed-dollar assets—lose purchasing power.
When the "bust" finally comes and he is put out of work, his relatively small dollar savings might not be enough to enable him to meet loan payments on his home or car. Thus, he runs a grave risk of losing his built-up equity to the financial institutions that loaned him the money to buy them.
8. Inflation paves the way for dictatorial control of a nation in much the same way that Hitler and Mussolini rose to power forty years ago. It divides people into conflicting factions. Instead of voluntarily cooperating to solve important problems, various groups tend to become antagonistic toward each other.
The end result of continued inflation is to weaken a nation in every respect: Its economic and social structure, its productive capacity, and the standard of living of its people. Thus is a country’s economy disrupted and made ripe for easy takeover.
More effects of inflation could be cited, but they all point in one direction: to the final concentration of all power in the central government. This dangerous tendency can be reversed if we recognize that long-term expansion of our money supply can be brought about only through the Federal government and its agency, the Federal Reserve System. Thus, our government must be held responsible for inflation—though we, as citizens, remain finally accountable for what we allow our government to do.